2 simple ways to predict and prevent business failure

Main reasons that business fail:

Most companies tend to go out of business either because (i) industry conditions dictate how the business behaves or what it produces (new technology means more obsolescence) or because; (ii) the company/management of the company is weak or unmotivated; or (iii) the finances of the company were mismanaged (low profits and insufficient cash).

General Warning signs:

The warning signs are

• Lack of/low operating cash flow

• High amount of overdue supplier invoices (inability to pay)

• Operating losses

• Breaking bank loan covenants

• High staff/supplier turnover

• Changes in technology

• Changes in legislation

• Compliance issues with regulations

These warning signs should be used as ‘common sense’, but the two models discussed today are good ways of keeping an eye on technical aspects, and give you a definitive and non-objective way of measuring company success (or failure).

Method 1: Altman’s Z Score (Quantitative Model) – adapted for small and medium size companies

The original Z Score was developed in 1968 and was intended to be used as “Multi-discriminatory Analysis”, which means it uses various ratios multiplied by weightings (based on importance of ratio). Originally, there was 22 ratios across five categories (liquidity, profitability, leverage, solvency, and activity), but eventually this was pared down to five of the best predictive ratios. Before Altman, William Beaver discovered that the ‘cashflow to total debt’ ratio was the most significant in predicting corporate failure. Altman’s study was based on listed manufacturing companies, some failed and some successful, in determining whether his model would work. For the purpose of this article, we are using an adapted Z Score which is more helpful in predicting SME failure.

Altman suggested that scores above 2.9 meant that the business was in safe water. Companies scoring between 1.23 and 2.89 were in dire straits but could be ‘turned around’. Scoring below 1.23 meant imminent failure in the near future. The score has a success rate of 70%-80% but, given that the model is meant to predict and prevent failure, it is possibly even closer to 90% accurate, because the model forces businesses to take action.

William Beaver discovered that the ‘cashflow to total debt’ ratio was the most significant in predicting corporate failure

Although seemingly technical in nature, it is not beyond the non-accountant to calculate the Z score. It is a pretty simple ‘plug and pray’ formula which is made even more simple using the spreadsheet attached to this article. The formula is expressed as follows:

Z = 3.107(X1) + 0.998 (X2) + 0.420 (X3) + 0.717 (X4) + 0.847 (X5)

where:

X1 = Earnings before interest and tax ÷ Total Assets

X2 = Net Sales ÷ Total Assets

X3 = Book Value of Equity ÷ Total Liabilities

X4 = Working Capital* ÷ Total Assets

X5 = Retained Earnings ÷ Total Assets

*Working Capital = Current Assets – Current Liabilities

You will need your latest adjusted Trial Balance (Profit and Loss + Balance Sheet) to obtain these figures, found here:

Method 2: Argenti’s A Score (Qualitative Model) – for use in any organisation

As the A score is based on qualitative data, it is therefore considered far more objective, requiring the user to be judgmental and unbiased, and therefore we recommend that you hire an accountant whose has no objective interest in your business to assess this score.

Opposite to the Z Score, the aim is to score as low as possible (1 being the best score). Generally though, scores below 27 mean the business is not considered at risk of failure.

The A Score progresses through three main factors: Defects, Mistakes, and Symptons, with scoring at each progressive level meant as an indicator of worsening risk.

Defects of the Company

Defects mainly include Management Weakness and Accounting Deficiencies. Use the following to count your score for your business (be subjective here).

^Maximum points in [square brackets]

Management Weaknesses:

• Autocratic Managing Director (e.g. domineering boss) [8 points]

• Passive upper management (e.g. being reactive instead of proactive) [2 points]

• Lack of balance of skills in management team (e.g. too many accountants, not enough marketing experts) [4 points]

• Weak Finance Director [2 points]

• Slow/poor response to change [15 points]

Accounting Deficiencies:

• No budgetary control (no monthly statements/reconciliations/forecasts etc) [3 points]

• No cash flow plans [3 points]

• No system used for costing [3 points]

Mistakes Made by the company

• High financial gearing – a company allows gearing to rise to such a level that one unfortunate event can have disastrous consequences [15 points]

• Overtrading – this occurs when a company expands faster than its financing is capable of supporting. The capital base can become too small and unbalanced [15 points]

• The Big Project – any external/internal project, the failure of which would bring the company down [15 points]

Symptoms of Failure

• Financial signs – in the A score context, these appear only towards the end of the failure process, in the last two years. [4 points]

• Creative accounting – optimistic statements are made to the public and figures are altered (inventory valued higher, depreciation lower, etc). Because of this, the outsider may not recognise any change, and failure, when it arrives, is therefore very rapid. [4 points]

• Non-financial signs – various signs include frozen management salaries, delayed capital expenditure, falling market share, rising staff turnover. [3 points]

• Terminal signs – at the end of the failure process, the financial and non-financial signs become so obvious that even the casual observer recognises them. [1 point]

Uh-oh. I’m still unsure how this works, help!

Talk to your accountant – or even better, talk to us!

Let’s wrap this up

So there you have it – hopefully the whole business failure thing is a little more clear and a little less scary to you. Of course, if you are still boggled by it or just want to make sure it is done right, book a free Discovery Call with us today.

Disclaimer: This guide is for informational purposes only and specific accounting and tax advice should always be obtained where appropriate.